COVER STORY: Interchange Fees: The tipping point
When it comes to modern payment methods, plastic rules. But when it comes to the spreading fallout from interchange fees, retailers are crying, enough is enough.
It was just three years ago that a historic milestone occurred in the United States: For the first time, electronic payments exceeded check payments. The trend isn't likely to die down any time soon, either, as consumers continue to opt for the convenience and security that credit and debit cards offer.
Yet along with the consumer appeal that accompanies these payment methods, an unwelcome consequence has emerged for increasingly frustrated supermarkets and other merchants: escalating interchange fees. These fees, which merchants pay to the banks that issue Visa and MasterCard credit and debit cards to help offset costs, have increased 10 times since 1998, and four times in the last two years, according to estimates by the Food Marketing Institute. By 2004 the average interchange fee had reached 1.75 percent, according to a Morgan Stanley report, and the fees are forecast to grow to 1.86 percent by 2010.
To some businesses those rates may not sound like much of a price to pay in support of a payment system that otherwise benefits shoppers and merchants alike. But for supermarket operators, for whom every penny counts, it's gotten to the point where something's got to give.
To express it in supermarket-centric terms, Cincinnati-based Kroger said last year that it expected to pay credit and debit interchange fees of approximately $350 million, up more than 215 percent from five years ago. And Sunbury, Pa.-based Weis Markets said in its second-quarter earnings report last July that over the past decade, substantial rate increases and higher customer usage had boosted interchange fee costs a whopping 582 percent.
New model needed
Simply put, these fees have grown to the point that they exceed the average retailer's net profits. The expenses eventually find their way onto the shelves, in the form of higher prices, which hurt all shoppers regardless of what form of tender they use.
It's a competitive model that's gone awry, and is in dire need of fixing, supermarket industry leaders argue.
"One of the contemporary terms we hear today is 'the tipping point,'" notes Thomas K. Zaucha, president and c.e.o. of the National Grocers Association. "In our view the tipping point is when interchange fees begin to exceed the cost of doing business and the profitability of the stores.
"When you go back to the evolution of credit and debit cards and their associations, we've been very proactive in looking at the use of these as a credible alternative to the cost and issues involved with cashing checks," continues Zaucha. "But when greed begins to set in and costs continue to increase, then it reaches the point where you say, enough is enough."
The crisis is uniting an industry otherwise known for cutthroat competition. As FMI's president and c.e.o., Tim Hammonds, sees it, "Grocers are all in this boat together." While the usage of credit cards still varies from region to region, many of FMI's members now see more than half of transactions from plastic, he says. For the past two years, FMI's board of directors has marked the problem of interchange fees as their No. 1 priority. "I think it's because everyone has concluded that the greed of credit card companies knows no limits," says Hammonds.
Joining forces
Ballooning interchange fees have spurred FMI, NGA, and the National Retail Federation, among other trade groups, to take action of both the legal and educational kinds. They've joined forces to form the multichannel Merchant Payment Coalition, in the hope of educating the public at large, from politicians and the Federal Reserve Board to consumers. Scores of retailers are taking legal action, too, either together or individually. Albertsons, Hy-Vee, Kroger, Publix, and Safeway are among the 50-plus companies that have filed class actions against Visa and/or MasterCard in some form. (See sidebar on page 19 for more details.)
But legal proceedings and educational efforts take time. For some companies the costs are just too out of control, and time is of the essence.
While biometric payment systems have been gaining ground as one alternative that cuts down on fees, some retailers are taking the payment matter into their own hands. In one example, Binghamton Giant Markets, a 12-store operator in Vestal, N.Y., is offering customers its own branded debit card, Giant Extra Plus.
The idea of unilateral action may be catching on. Zaucha says NGA is developing a national merchant-controlled credit and/or debit card of its own. Several of its members have already signed on to pilot the cards later this year.
Fee fallout
In years past, retailers saw interchange fees as necessary, if burdensome, consequences of the plastic revolution. But as interest rates have been gone down and the technological prowess of electronic payment has vastly improved, usage of credit cards is at an all-time high -- yet fees still climb. Hammonds and other industry representatives are loudly demanding answers for why the fee increases haven't let up.
Critics argue that Visa and MasterCard use higher interchange fees in part to sweeten their deals with network banks and discourage them from striking partnerships with their rival, American Express, which operates under a three-party system, as opposed to the four-party system that Visa and MasterCard operate under. Others point to the aggressive marketing tactics of the credit card firms, ranging from splashy billboard advertising to direct-mail deluges. Retailers feel shortchanged because they're paying higher fees for premium cards that give affluent customers perks.
Card firms counter
In defense of interchange fees, Rhonda Bentz, v.p. of public affairs for Visa USA, explains that the fees get reinvested back into the system to support many important technologies, such as fraud and security solutions and the network that can process more than 10,000 transations per second. And as for subsidizing more affluent customers, aren't they the shoppers grocers want in the stores?
From Visa's point of view, setting the right interchange fees is tricky, says Bentz. "Visa places a premium on our ability to strike a balance between the need to have financial institutions issue our cards and merchants accepting them," she says. "If we set rates too low, we risk losing issuance; set rates too high, and we risk losing acceptance. As delicate a balancing act as that is, it's also an incredible way of connecting millions of merchants with billions of consumers around the world."
But in many other parts of the world, interchange fees are lower, which is another sticking point for fee-wary retailers. Fact: The United States pays the highest interchange fees of any of the developed countries. Merchants in other countries have complained that their rates are also too high, however. Australian and European merchants have prompted their governments to investigate the practice, and the Reserve Bank of Australia has intervened, lowering the fees that merchants pay. The results of its action have been good and bad, depending on whom you ask.
Before the U.S. Federal Reserve Board gets involved, if indeed it ever does, the retail industry has a lot of teaching to do. "This is a relatively new issue for people in regulatory agencies or on Capitol Hill," says Hammonds. "We're in the education phase right now. But there's a lot of interest. People recognized, for example, that when the price of gas spiked, credit card income skyrocketed."
During a Feb. 15 hearing on "The Law and Economics of Interchange Fees," Hammonds and Henry Armour, president and c.e.o. of the National Association of Convenience Stores, submitted comments to the U.S. House of Representatives Subcommittee on Commerce, Trade, and Consumer Protection, which falls under the Committee on Energy and Commerce. Representatives from the Electronic Payments Coalition and the Small Business and Entrepreneurship Council were there to defend Visa and MasterCard's practices.
MasterCard submitted a statement after the hearing, contending that merchants of all sizes benefit from accepting payment cards, in terms of increased sales, guaranteed payment, and the management of lending losses, fraud, and complying with existing regulations. "The fact is that merchants pay an extremely small amount for the phenomenal value they get from accepting masterCard cards," the company said. It argued that merchants who want price controls are simply trying to increase their profits by passing on more of the costs of doing business to consumers.
Retailers' battle on Capitol Hill is likely to be largely uphill, especially when you consider that the credit card lobby is one of Washington's most powerful and best funded, according to Hammonds.
Still, he says, FMI will continue to testify at legislative hearings. "We've also worked with the Federal Reserve Board on the regulatory side. We believe they could regulate fees, if they chose to do so."
Hammonds adds that FMI will "launch something more general for consumers later in the year," but would not offer specifics.
When asked whether FMI would consider launching its own payment system, he says that the group looked into it, but concluded that it wasn't feasible.
War for independents
NGA determined otherwise. "In our opinion it's critical to our overall strategy and ultimate success to develop an alternative payment system," says Zaucha.
NGA is particularly frustrated by what it considers discrimination against smaller operators by the credit card companies and their networks. "Whether you do 1 million transactions or 10,000, there's no way to rationalize greater economies of efficiency that would rationalize company A getting lower rates than company B, just because they have more transactions," says Zaucha. "Our interest in litigation is to change the structure of the current method of setting price."
Another likely factor in NGA's decision to develop an alternative payment system was its background in payment processing. "We've been in the processing business for some 15 years," explains the trade group's top exec. "We have a lot of experience with our major partner, First Data, as well as processors."
NGA's Merchant Card Task Force, formed last fall to develop a business solution, is leaning toward a retailer-issued ACH debit card linked to loyalty card programs, which could conceivably provide interoperability between retailers, perhaps even nationwide. "There are certain merchants who have made the decision to pilot this program," says Stu Zlotnikoff, an NGA s.v.p. and co-chairman of the Merchant Payment Coalition's Market Solution subcommittee. He confirms that the pilot will begin later this year.
Zlotnikoff further explains the strategy that NGA has in mind. "The concept isn't to try and have a national brand like NGA, but to have that in the background. The card would feature the name of the merchant."
Regional retailers' brands are strong enough to carry such a program, in Zaucha's opinion. "The brand names of the grocers may in fact have greater credibility with customers than the name on their current credit or debit card. So many of these retailers already have loyalty programs. Why not tie in the payment method?"
At least one independent retailer has already made the switch. Binghamton Giant Markets in upstate New York has issued its own ACH debit card since 1989. Although the company took a brief hiatus during the Y2K scare, it's now back up and running with the Giant Extra Plus debit card, which is powered by payment network technology from Debitman Card. The retailer maintains its own bank switch, so the cards go through its authorization internally.
"Customers can use the cards to write checks, or as a debit card," says Jim Whittaker, director of management support services at Binghamton Giant Markets. "We've found there are significant advantages to using this card: less cost per transaction, a faster transaction at checkout, and a definite loyalty aspect with customers." While the retailer doesn't have a loyalty card program, it still sees the debit card as a brand enforcer.
Customers like the security benefit of the card, too, says Whittaker. "Honestly, it's a more secure transaction because it's PIN-enforced."
Payment network
Another advantage to the card is that it can be used at other supermarkets, drug stores, or other local merchants if they decide to join the payment network.
This approach could appeal to retailers throughout the country. "If the interchange rate on credit cards remains where it is, retailers will continue to have to look at cheaper cost alternatives, whether ACH, biometric tie-ins to ACH, or something else," says John Briggs, s.v.p., c.f.o., and treasurer of Hy-Vee, Inc.
For now it may be all that retailers can do. They're certainly barred from talking to customers directly about the "hidden fees" that they end up paying in the stores. And they're outgunned by the credit card giants.
"We're talking about a fundamental change in how Visa and MasterCard do business, so this would obviously have a dramatic impact," notes Briggs. "They'll obviously protect themselves."
This hulking cloud over profits could have at least one silver lining, however. Industry watchers are keeping a close eye on the actions of the new c.e.o. at Visa, John Coghlan, who early on in his career was co-founder and c.o.o. of San Francisco Grocery Express, Ltd., a Internet-based direct-response catalog grocery delivery service. Retailers are hoping that Coghlan might be more sympathetic to the supermarket industry's concerns.
"One of the first things Mr. Coghlan has done is to meet with the National Retail Federation and other merchants," says Visa's Bentz. "He wants to understand their concerns."
NRF's s.v.p. and general counselor, Mallory Duncan, acknowledges that Coghlan is making an effort to reach out to retail customers. "But he has a monumental amount of bad feeling out there that he has to overcome," says Duncan. "He's coming into an environment in which the organization has shown itself to be anti-retailer."
It was just three years ago that a historic milestone occurred in the United States: For the first time, electronic payments exceeded check payments. The trend isn't likely to die down any time soon, either, as consumers continue to opt for the convenience and security that credit and debit cards offer.
Yet along with the consumer appeal that accompanies these payment methods, an unwelcome consequence has emerged for increasingly frustrated supermarkets and other merchants: escalating interchange fees. These fees, which merchants pay to the banks that issue Visa and MasterCard credit and debit cards to help offset costs, have increased 10 times since 1998, and four times in the last two years, according to estimates by the Food Marketing Institute. By 2004 the average interchange fee had reached 1.75 percent, according to a Morgan Stanley report, and the fees are forecast to grow to 1.86 percent by 2010.
To some businesses those rates may not sound like much of a price to pay in support of a payment system that otherwise benefits shoppers and merchants alike. But for supermarket operators, for whom every penny counts, it's gotten to the point where something's got to give.
To express it in supermarket-centric terms, Cincinnati-based Kroger said last year that it expected to pay credit and debit interchange fees of approximately $350 million, up more than 215 percent from five years ago. And Sunbury, Pa.-based Weis Markets said in its second-quarter earnings report last July that over the past decade, substantial rate increases and higher customer usage had boosted interchange fee costs a whopping 582 percent.
New model needed
Simply put, these fees have grown to the point that they exceed the average retailer's net profits. The expenses eventually find their way onto the shelves, in the form of higher prices, which hurt all shoppers regardless of what form of tender they use.
It's a competitive model that's gone awry, and is in dire need of fixing, supermarket industry leaders argue.
"One of the contemporary terms we hear today is 'the tipping point,'" notes Thomas K. Zaucha, president and c.e.o. of the National Grocers Association. "In our view the tipping point is when interchange fees begin to exceed the cost of doing business and the profitability of the stores.
"When you go back to the evolution of credit and debit cards and their associations, we've been very proactive in looking at the use of these as a credible alternative to the cost and issues involved with cashing checks," continues Zaucha. "But when greed begins to set in and costs continue to increase, then it reaches the point where you say, enough is enough."
The crisis is uniting an industry otherwise known for cutthroat competition. As FMI's president and c.e.o., Tim Hammonds, sees it, "Grocers are all in this boat together." While the usage of credit cards still varies from region to region, many of FMI's members now see more than half of transactions from plastic, he says. For the past two years, FMI's board of directors has marked the problem of interchange fees as their No. 1 priority. "I think it's because everyone has concluded that the greed of credit card companies knows no limits," says Hammonds.
Joining forces
Ballooning interchange fees have spurred FMI, NGA, and the National Retail Federation, among other trade groups, to take action of both the legal and educational kinds. They've joined forces to form the multichannel Merchant Payment Coalition, in the hope of educating the public at large, from politicians and the Federal Reserve Board to consumers. Scores of retailers are taking legal action, too, either together or individually. Albertsons, Hy-Vee, Kroger, Publix, and Safeway are among the 50-plus companies that have filed class actions against Visa and/or MasterCard in some form. (See sidebar on page 19 for more details.)
But legal proceedings and educational efforts take time. For some companies the costs are just too out of control, and time is of the essence.
While biometric payment systems have been gaining ground as one alternative that cuts down on fees, some retailers are taking the payment matter into their own hands. In one example, Binghamton Giant Markets, a 12-store operator in Vestal, N.Y., is offering customers its own branded debit card, Giant Extra Plus.
The idea of unilateral action may be catching on. Zaucha says NGA is developing a national merchant-controlled credit and/or debit card of its own. Several of its members have already signed on to pilot the cards later this year.
Fee fallout
In years past, retailers saw interchange fees as necessary, if burdensome, consequences of the plastic revolution. But as interest rates have been gone down and the technological prowess of electronic payment has vastly improved, usage of credit cards is at an all-time high -- yet fees still climb. Hammonds and other industry representatives are loudly demanding answers for why the fee increases haven't let up.
Critics argue that Visa and MasterCard use higher interchange fees in part to sweeten their deals with network banks and discourage them from striking partnerships with their rival, American Express, which operates under a three-party system, as opposed to the four-party system that Visa and MasterCard operate under. Others point to the aggressive marketing tactics of the credit card firms, ranging from splashy billboard advertising to direct-mail deluges. Retailers feel shortchanged because they're paying higher fees for premium cards that give affluent customers perks.
Card firms counter
In defense of interchange fees, Rhonda Bentz, v.p. of public affairs for Visa USA, explains that the fees get reinvested back into the system to support many important technologies, such as fraud and security solutions and the network that can process more than 10,000 transations per second. And as for subsidizing more affluent customers, aren't they the shoppers grocers want in the stores?
From Visa's point of view, setting the right interchange fees is tricky, says Bentz. "Visa places a premium on our ability to strike a balance between the need to have financial institutions issue our cards and merchants accepting them," she says. "If we set rates too low, we risk losing issuance; set rates too high, and we risk losing acceptance. As delicate a balancing act as that is, it's also an incredible way of connecting millions of merchants with billions of consumers around the world."
But in many other parts of the world, interchange fees are lower, which is another sticking point for fee-wary retailers. Fact: The United States pays the highest interchange fees of any of the developed countries. Merchants in other countries have complained that their rates are also too high, however. Australian and European merchants have prompted their governments to investigate the practice, and the Reserve Bank of Australia has intervened, lowering the fees that merchants pay. The results of its action have been good and bad, depending on whom you ask.
Before the U.S. Federal Reserve Board gets involved, if indeed it ever does, the retail industry has a lot of teaching to do. "This is a relatively new issue for people in regulatory agencies or on Capitol Hill," says Hammonds. "We're in the education phase right now. But there's a lot of interest. People recognized, for example, that when the price of gas spiked, credit card income skyrocketed."
During a Feb. 15 hearing on "The Law and Economics of Interchange Fees," Hammonds and Henry Armour, president and c.e.o. of the National Association of Convenience Stores, submitted comments to the U.S. House of Representatives Subcommittee on Commerce, Trade, and Consumer Protection, which falls under the Committee on Energy and Commerce. Representatives from the Electronic Payments Coalition and the Small Business and Entrepreneurship Council were there to defend Visa and MasterCard's practices.
MasterCard submitted a statement after the hearing, contending that merchants of all sizes benefit from accepting payment cards, in terms of increased sales, guaranteed payment, and the management of lending losses, fraud, and complying with existing regulations. "The fact is that merchants pay an extremely small amount for the phenomenal value they get from accepting masterCard cards," the company said. It argued that merchants who want price controls are simply trying to increase their profits by passing on more of the costs of doing business to consumers.
Retailers' battle on Capitol Hill is likely to be largely uphill, especially when you consider that the credit card lobby is one of Washington's most powerful and best funded, according to Hammonds.
Still, he says, FMI will continue to testify at legislative hearings. "We've also worked with the Federal Reserve Board on the regulatory side. We believe they could regulate fees, if they chose to do so."
Hammonds adds that FMI will "launch something more general for consumers later in the year," but would not offer specifics.
When asked whether FMI would consider launching its own payment system, he says that the group looked into it, but concluded that it wasn't feasible.
War for independents
NGA determined otherwise. "In our opinion it's critical to our overall strategy and ultimate success to develop an alternative payment system," says Zaucha.
NGA is particularly frustrated by what it considers discrimination against smaller operators by the credit card companies and their networks. "Whether you do 1 million transactions or 10,000, there's no way to rationalize greater economies of efficiency that would rationalize company A getting lower rates than company B, just because they have more transactions," says Zaucha. "Our interest in litigation is to change the structure of the current method of setting price."
Another likely factor in NGA's decision to develop an alternative payment system was its background in payment processing. "We've been in the processing business for some 15 years," explains the trade group's top exec. "We have a lot of experience with our major partner, First Data, as well as processors."
NGA's Merchant Card Task Force, formed last fall to develop a business solution, is leaning toward a retailer-issued ACH debit card linked to loyalty card programs, which could conceivably provide interoperability between retailers, perhaps even nationwide. "There are certain merchants who have made the decision to pilot this program," says Stu Zlotnikoff, an NGA s.v.p. and co-chairman of the Merchant Payment Coalition's Market Solution subcommittee. He confirms that the pilot will begin later this year.
Zlotnikoff further explains the strategy that NGA has in mind. "The concept isn't to try and have a national brand like NGA, but to have that in the background. The card would feature the name of the merchant."
Regional retailers' brands are strong enough to carry such a program, in Zaucha's opinion. "The brand names of the grocers may in fact have greater credibility with customers than the name on their current credit or debit card. So many of these retailers already have loyalty programs. Why not tie in the payment method?"
At least one independent retailer has already made the switch. Binghamton Giant Markets in upstate New York has issued its own ACH debit card since 1989. Although the company took a brief hiatus during the Y2K scare, it's now back up and running with the Giant Extra Plus debit card, which is powered by payment network technology from Debitman Card. The retailer maintains its own bank switch, so the cards go through its authorization internally.
"Customers can use the cards to write checks, or as a debit card," says Jim Whittaker, director of management support services at Binghamton Giant Markets. "We've found there are significant advantages to using this card: less cost per transaction, a faster transaction at checkout, and a definite loyalty aspect with customers." While the retailer doesn't have a loyalty card program, it still sees the debit card as a brand enforcer.
Customers like the security benefit of the card, too, says Whittaker. "Honestly, it's a more secure transaction because it's PIN-enforced."
Payment network
Another advantage to the card is that it can be used at other supermarkets, drug stores, or other local merchants if they decide to join the payment network.
This approach could appeal to retailers throughout the country. "If the interchange rate on credit cards remains where it is, retailers will continue to have to look at cheaper cost alternatives, whether ACH, biometric tie-ins to ACH, or something else," says John Briggs, s.v.p., c.f.o., and treasurer of Hy-Vee, Inc.
For now it may be all that retailers can do. They're certainly barred from talking to customers directly about the "hidden fees" that they end up paying in the stores. And they're outgunned by the credit card giants.
"We're talking about a fundamental change in how Visa and MasterCard do business, so this would obviously have a dramatic impact," notes Briggs. "They'll obviously protect themselves."
This hulking cloud over profits could have at least one silver lining, however. Industry watchers are keeping a close eye on the actions of the new c.e.o. at Visa, John Coghlan, who early on in his career was co-founder and c.o.o. of San Francisco Grocery Express, Ltd., a Internet-based direct-response catalog grocery delivery service. Retailers are hoping that Coghlan might be more sympathetic to the supermarket industry's concerns.
"One of the first things Mr. Coghlan has done is to meet with the National Retail Federation and other merchants," says Visa's Bentz. "He wants to understand their concerns."
NRF's s.v.p. and general counselor, Mallory Duncan, acknowledges that Coghlan is making an effort to reach out to retail customers. "But he has a monumental amount of bad feeling out there that he has to overcome," says Duncan. "He's coming into an environment in which the organization has shown itself to be anti-retailer."